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Volkswirtschaft - Open Access LMU - Teil 01/03 Podcast
Strategic Trading and Learning about Liquidity

Strategic Trading and Learning about Liquidity

Volkswirtschaft - Open Access LMU - Teil 01/03 vor 25 Jahren

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Many practitioners point out that the speculative profits of
institutional traders arc eroded by the difficulty in gauging the
price impact of their trades. In this paper. we develop a model of
strategic trading where speculators face such a dilemma because of
incomplete information about time-varying market liquidity. Unlike
the competitive market makers that they trade against, informed
traders do not know whether the liquidity ( "noise") trades are
generated from a distribution with high or low variance. Instead,
they have to learn about liquidity from past prices and trading
volume. Extreme price deviations from forecasts of fundamentaIs
based on public news or low trading volume tend to lead to
revisions of beliefs in favor of the low liquidity state. This
revision in beliefs implies that strategie trades and market
statistics such as informational efficiency arc path-dependent on
past market outcomes. Our paper has a number of normative
implications for practitioners concerned with gauging the potential
price impact of their trades.